A Complex Regulatory Tapestry: Derivatives Reform Meets Basel III

This is the third in our series of weekly blog posts on the topic of over-the-counter (OTC) derivatives reform.

In addition to the regulations directly affecting the OTC derivatives market, new capital rules for banks are indirectly impacting derivatives trading. Firms will greatly benefit from understanding the links between these different regulations.

Much has been written about the impact of the Dodd-Frank Act and the European Market Infrastructure Regulation (EMIR) on the OTC derivatives market. Yet there is another regulatory angle that has, as yet, been overlooked by many firms - namely the interplay of derivatives reform with Basel III’s new capital framework.

The updated bank capital rules have been in force since 1 January, 2014 for all banks in Europe and for advanced banks in the U.S. They are also fully effective in 14 other jurisdictions, including Canada, China, India, and South Korea. Part of a broad-ranging financial reform campaign by regulators, these new rules encourage the use of central counterparties (CCPs) for clearing OTC derivative transactions.

This ‘encouragement’ involves the imposition of additional capital requirements for banks’ exposures to non-CCP counterparties in bilateral OTC derivatives transactions (i.e. uncleared trades). Furthermore, the rules introduce a nominal 2% risk weighting for certain derivative transactions (OTC and exchange-traded) cleared through a CCP, according to Baker & McKenzie.

In short, there are significant capital incentives for banks to trade centrally cleared OTC derivatives.  It is also likely that banks will incorporate the additional capital costs for any uncleared OTC derivatives when pricing new trades with their counterparties (with the only exclusion being hedging trades by non-financial companies that do not exceed the clearing thresholds defined by EMIR).

Interwoven Impacts

Given that banks are the typical counterparties in an OTC derivative trade, Basel III is relevant not just to financial institutions, but to all firms. Indeed, having a thorough understanding of the new Basel III rules could allow non-bank organisations to better assess the potential pricing proposed by banks during an OTC transaction.

Elsewhere, the Basel III, Dodd-Frank and EMIR rules interact when regulating centrally-cleared OTC derivatives. According to King & Wood Mallesons, under Basel III, banks that act as clearing members of a CCP must set aside capital for their contribution to the CCP’s Default Fund – one of the CCP’s layers of defence in the ‘default waterfall’, as defined under Dodd-Frank and EMIR (see Figure 1). 

FIGURE 1 – The Default Risk Protection System of a Clearing House (CCP)

The Default Risk Protection System of a Clearing House (CCP)

So, whilst Dodd-Frank, EMIR and Basel III may have evolved separately and are being driven and implemented by a number of national and international regulatory bodies, they have joint goals and joint impacts. In order to see the full picture, firms must therefore consider the combined effect of these regulations on their derivatives activity.

Our “Understanding The New OTC Derivatives Landscape” whitepaper examines how structural change in the OTC derivatives market will affect the way financial and non-financial firms operate and the need for firms to consider how they will navigate the evolving regulatory landscape and fast-moving OTC derivatives market. Read it here.

This is part of a series of blog posts on the OTC derivatives reform. Read our other blogs “Central Clearing Begins To Bite” and “OTC Derivatives Reform: Will Electronification Pay?”. 

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